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A market opportunity: hybrid debt

The expansion of the coronavirus has brought entire economies to a sudden stop. The shock has particularly impacted the equity and fixed income markets. Hybrid debt has not been spared.

Hybrid debt, a market opportunity

The expansion of the coronavirus has brought entire economies to a sudden stop. The shock has particularly impacted the equity and fixed income markets. Hybrid debt has not been spared.

Today, after the major widening of spreads in the credit market as a whole, we consider that the hybrid debt segment has regained significant levels of attractiveness in a context where governments and central banks are providing support to companies and endeavouring to prevent bankruptcies at all costs, with the aim of enabling the economy to bounce back when the health crisis is over.

Consequently, in the hybrid debt market, relative value opportunities have been created, following a significant dislocation of the credit market, with levels of market correction that are in many cases out of all proportion to the solidity of the companies concerned and to their liquidity and their ability to rapidly adjust their cost bases.

Finally, our positioning in the fund prioritizes in particular non-cyclical and defensive sectors.

Characteristics of “hybrid” bonds

As a reminder, a hybrid bond is a debt instrument with very long maturity, or without maturity (a perpetual bond or “perp”) issued by a company, with the possibility for the company to redeem the debt after a fixed number of years (generally after 5 years). Hybrid bonds combine characteristics of conventional bonds (fixed coupon, optional call date etc.) with characteristics of equity (distribution of discretionary coupons, possibility of no maturity date). Also, they are regarded by rating agencies as capital (50% equity / 50% debt) . These instruments cannot be converted into equity: there is no trigger nor loss absorption, except – as with senior debt – in the case of default. Finally, the coupons are deferrable but cannot be cancelled.

The main attraction of hybrid debt instruments for investors is the fact that they provide higher yield than the senior debt instruments from the same issuer.

Attractiveness of the asset class

Today, we consider this asset class to be attractive for several reasons.

First, the spreads between senior and subordinated debt have returned to their historic levels of 2016, reaching 300 basis points (on 26 March 2020), compared to approximately 150 basis points (bps) in March 2019 (see graph below).

Second, although it is true that the assistance provided by the European Central Bank (ECB) does not target hybrid debts, which officially have maturity dates longer than 30 years, many issuers of hybrid debt will nevertheless receive ECB support through the purchase of their senior debt as part of the ECB asset purchase programmes. Massive purchasing of these Investment Grade debts will have the effect of reining in the spreads, thereby mechanically narrowing the spreads of hybrid issues.

Source: Bloomberg, Crédit Suisse. Data as on 27 April 2020.

Sector opportunities

The massive outflows from corporate debts has impacted the entire market indiscriminately, with no real distinction between individual sectors, even though not all companies are equally affected by the crisis. For example, in the Telecommunications sector, which has been relatively spared by the Covid-19 crisis, although corporate spreads have somewhat widened on senior debt they have widened much more significantly on the hybrid debt segment, with the result that, in March 2020, the spread between senior and hybrid debt reached a level not been seen since early 2016:

Source: Bloomberg, Crédit Suisse. Data as on 27 April 2020.

Consequently, we have increased our investments in this sector, which already had significant weight in our portfolio, by purchasing the hybrid debts of British Telecom and Vodafone.

The real estate sector has been significantly disrupted during the crisis. In our opinion, residential real estate will fare better than commercial or office real estate, and so we took advantage of the spread to make repeated purchases of the hybrid debt issued by German company Vonovia, which specializes in residential real estate.

Opportunities on hybrids denominated in currencies other than the euro

The hybrid securities market essentially comprises Europeans. In a stressed market, the bond issues that are hit hardest by pricing dislocations are traditionally those denominated in currencies other than the currencies most commonly used by the investors, in this case currencies other than the euro. An illustration is provided below, with a comparison between the pricing over time of hybrid debt issues denominated in dollars and in euros:

Source: Bloomberg, Crédit Suisse. Data as on 27 April 2020.

As you can see, since the end of February, the dislocation has even spread to different issues of the same issuer, as in the case of KPN, whose dollar issue with a maturity date in 2073 rose by 400 bps, compared to less than 200 bps for the hybrid perp in euros, even though these two issues were traded at equivalent levels before the crisis:

Source: Bloomberg. Data as on 27 April 2020.

Consequently, we initiated a position on KPN hybrid debt denominated in dollar. We adopted the same approach for Orange, which issued a hybrid issue in GBP, and for the British company SES Utilities.

Characteristics and positioning of our portfolio

The hybrid debt class has already rebounded from its lowest levels. However, the journey back to normalization is far from over.

Characteristics

Yield to call: 3.41%

Yield to maturity: 3.20%

Spread: 308 bp

Sensitivity to interest rates: 3.3

Data as on 27 April 2020. Source: Groupama Asset Management

By comparison, the yield to call on 31 December 2019 was 1.5%.

Positioning

Our hybrid debt portfolio began 2020 with a cautious approach, suspicious of the pricing levels of this asset class. This meant that we were less heavily impacted than the overall hybrid debt market during the period of market correction during February – March.

In the current context, the core of the portfolio, comprising in particular Utilities (35.9%) and Telecommunications (19%), has been relatively unaffected on both the supply and demand side. Moreover:

Often, issuers in the Utilities and Telecom sectors have State as stakeholder and have very solid liquidity.

These issuers always have access to the primary market and are purchased by the ECB.

Since the peak of the Covid-19 crisis, we have increased our exposure to the hybrid debt market to take advantage of the current opportunities.

Distribution per sector as on 29 April 2020:

Source : Groupama Asset Management

Performance

The fund is not built from a reference index. Since its launch last October 7th, the fund management has adopted a cautious positioning by favouring high credit quality issuers, assessing that valuation levels of the asset class were high. Thus, in 2020, G Fund Hybrid Corporate Bonds was less volatile than the hybrid Merrill Lynch benchmarks, euro and global. In the recovery phase started in March, the fund and the hybrid indices catch up Investment Grade credit indices (here Barclays index):

Sources: Groupama Asset Management, Bloomberg. Fund launched in October 7th 2019. G Fund Hybrid Corporate Bonds I-C share class- EUR : LU2023296168.Indices denominated in local currency. These indices are for informational purposes only and do not constitute a benchmark for the fund. Data as of April 28th 2020.

DISCLAIMER

This document is not intended for “non-professional” European Union investors, as defined in “MiFID” (EU Directive 2004/39/EC dated 21 April 2004) or any other local regulation. Similarly, in Switzerland, this document is not intended for investors not classified as “qualified investors” under the applicable legislation. As a general rule, this document must not be transmitted to private clients or individuals as defined in any legislation, nor to “US Persons”.

This document contains information concerning G FUND – HYBRID CORPORATE BONDS, a compartment of G Fund (also referred to as “the SICAV”), a Luxembourg-based undertaking for collective investment in transferable securities (UCITS), covered by part I of the Law dated 20 December 2002 and constituted in the form of a “SICAV”(Société d’Investissement à Capital Variable – a European publicly traded investment company structure for open-ended funds). The SICAV is registered with the Luxembourg Trade and Companies Register under number B157527. Its registered office address is 5, allée Scheffer, L-2520 Luxembourg. G Fund was authorized for trading by the Luxembourg financial authority CSSF (“Commission de Surveillance du Secteur Financier”).

Investors are advised that not all compartments of the SICAV are necessarily registered, authorized for commercialization or accessible to all investors in all jurisdictions. Before subscribing to a compartment, the client must take due note of the complete prospectus of the SICAV and of its latest annual and half-yearly reports and its articles of association. These documents are available free of charge at the registered office of the SICAV or at the registered office of the authorized representative accredited by the competent authority in each jurisdiction concerned.

Investment in the compartments of the SICAV involve risks. Investors must fully inform themselves of these risks before any subscription and must make sure that they have understood the present document. We recommend that all potential investors contact an advisor to determine whether this investment is suited to their profile.

The performance of a compartment is not guaranteed but can vary both upwards and downwards. The past performance of a compartment is not a reliable indicator of the future performance of the same compartment. Performance is quoted excluding the costs and commissions charged for subscription/redemption.

This document is not an investment recommendation. Similarly, this document does not constitute an offer of purchase or request to sell in countries where the compartments of the open-ended fund are not authorized to be traded or where any such offer or request would be illegal.

The commercial teams of Groupama Asset Management, the G FUND management company, are at your service if you wish a personal financial recommendation.